Hedge Funds And The Definition Challenge — Part 1

"This article was published originally in the

Commercial Law Practitioner and it is the copyright of Thomson

Round Hall"

Introduction

Seldom is an entire industry defined by default but in the

case of the "alternative investment" industry this

has proven true for nearly 60 years. Alternative investments,

or those investments outside what has been regarded as

traditional investments,1 comprise hedge funds,

private equity, venture capital, property funds and art. This

dilemma of definition by default gets more complex when we see

that constituent segments of the alternative investment

industry, such as hedge funds, are also defined by reference to

what they are not.

In Europe funds are categorised primarily as UCITS or

non-UCITS. A UCITS fund is an Undertaking for Collective

Investment in Transferable Securities (UCITS). This fund status

is granted on compliance with restrictions and requirements

contained in the UCITS Directive2 and represents an

EU passport system whereby qualifying funds can be marketed and

distributed cross-border. Attaining UCITS status means that

after the initial authorization of the fund in the home state

there are no further regulatory obligations imposed on the fund

when it is marketed and distributed in other member states.

However not all funds adhere to these restrictions and

requirements and therefore not all funds qualify as UCITS.

Those collective investment schemes which do not qualify are

frequently referred to as non-UCITS. Due to the lack of

restrictions and requirements that hedge funds wish to be

exposed to they do not attempt to satisfy the conditions of the

UCITS Directive and therefore fall into this latter category

and are identified by reference to what they are not.

This lack of definitional clarity, while facilitating the

commercial side of the hedge funds3 industry, is

likely to provide difficulty in the now imminent regulation of

the industry. Without a definition of the term "hedge

fund," regulation of the industry would be uncertain as

hedge fund managers and hedge funds would be unsure of their

regulatory status and creative compliance to avoid regulation

would be a risk. Similarly unintended regulatory

consequences4 would be sure to arise in areas close

to the hedge fund industry within the alternative investments

umbrella. Due to the similarity of hedge funds and private

equity funds there is a risk that in the absence of a

definition for the term "hedge fund" prospective

regulation may inadvertently have implications for private

equity funds as many characteristics, practices, and strategies

are shared. Another unintended regulatory consequence is that

this uncertainty may encourage fund managers or funds to

migrate to jurisdictions and foreign markets where such issues

do not exist.

Hurst5 states that "'Hedge fund' is

not a legally defined term since in general they are subject to

little or no regulation." However this is not an accurate

reflection on the current situation. A more accurate and

complete statement is that the term "hedge fund" has

no internationally accepted legal definition because each

jurisdiction categorizes hedge funds differently,6

and each jurisdiction has therefore only statutorily defined

the specific investment vehicles used in its own jurisdiction.

In a generic sense these different vehicles across different

jurisdictions are commonly and collectively referred to as

hedge funds.

Hurst seems to imply that the term "hedge fund" is

not defined because hedge funds are not, or very lightly,

regulated products. His statement is correct in certain

respects as most jurisdictions do not regulate hedge

funds7 but there are jurisdictions that do regulate

hedge funds and do have a statutory definition, such as South

Africa.8 It is important to understand that the lack

of regulation is not the reason why the term "hedge

fund" has avoided legal definition. The lack of an

international legal definition of the term "hedge

fund" has its roots in two major issues:

1. There is no international commercial framework for the

registration, marketing and distribution of hedge funds and

therefore defining the term "hedge fund" has not been

necessary from a commercial, regulatory, or tax perspective

because they have been domiciled offshore, and

2. European legislation in the area of financial services

has concentrated on regulation at service provider level and

not at product level so there has been less of an historical

policy emphasis on understanding products.

It is the argument of this article that although such a

European or international commercial regime is only currently

being debated the regulation of the industry is pushing ahead

from other perspectives9 and therefore a definition

of the term "hedge fund" is necessary.10

Without a working definition of this term any regulatory

measures introduced may be illusory. Regulation must seek to

establish legal certainty and in the absence of a definition it

is impossible for any regulatory measures introduced in

relation to hedge funds to be applied or enforced with any

degree of certainty.

The main issue here therefore becomes: how do you create an

internationally acceptable definition when there is so much

jurisdictional inconsistency? The two contrasting options which

are available are: (a) a prescriptive rules-based approach

where a definition is built upon the harmonization of technical

requirements, or (b) a higher level principles-based approach

where a definition is built upon commonly accepted and

recognised attributes. What this article sets out to achieve is

to not only to show that such a definition can and should be

developed in a principles-based form but to propose a

definition in such a format.11

In supporting my proposed definition, I will address two key

areas which will be broken into a two-part series. Part one of

this series will address the history of hedge funds and how

they have evolved over time due to significant economic events.

Based on these developments this section will also address the

existing explanations of the term "hedge fund" from a

select number of international jurisdictions to assess how

adequately regulators and legislators have captured the essence

of what hedge funds are in the wake of those significant

economic events. Key principles will be drawn and applied to a

prospective definition of the term "hedge fund".

Part two of this series will address the characteristics of

hedge funds. This is perhaps the most important issue as hedge

funds are difficult to describe but easy to identify by their

characteristics.12 These characteristics will be

central in my principles-based definition and my argument that

this approach can successfully overcome the current regulatory

dilemma of defining hedge funds as regulation looms. In the

absence of a clear definition regulatory measures introduced

will not be built on a foundation of legal certainty and

therefore of central importance to the regulation of hedge

funds is their definition and the setting out of boundaries

within which the regulation will apply. This section will also

address trading strategies which are another way of determining

if a fund is categorized as a hedge fund or a more traditional

mutual fund. This strategy classification is also crucial to a

principles-based definition of hedge funds and therefore I must

demonstrate how each strategy of a hedge fund is classified and

identified. This section will condense the many characteristics

and strategies which are "distinguishing features"

into key principles which represent "proposed rules"

and which constitute my proposed definition of the term

"hedge fund".

The concept of hedge funds and where it came from

Essential to an understanding of hedge funds is an

appreciation of where they originated and how they have changed

over time to what we know today as hedge funds. Hedge funds owe

their beginnings to nearly two hundred years of crisis and

development in the area of mutual funds. These developments

frequently followed adverse economic events and fashioned new

classes of investors. As investors in mutual funds altered

their appetite for the nature and levels of risk to which they

were exposed, financial innovation moved one step at a time

from mutual funds to what became known as hedge funds. The

change in investing techniques over time due to these economic

events is the understanding that is needed in order to define

the term "hedge fund".

In assessing how investing techniques have changed over time

we must acknowledge that this evolution of a new strand of

collective investing never posed a significant issue for policy

makers until a hedge fund known as Long Term Capital Management

(LTCM) was bailed out of nearly $5 billion of losses made as a

result of the Russian default and subsequent devaluation of the

ruble in late 1998, before LTCM hedge fund losses had been

restricted to their wealthy investors. However, LTCM evidenced

the ability of a single hedge fund to affect an entire

economy's financial stability and cause widespread

contagion in financial markets. Therefore we can split up the

history of hedge funds into two specific eras: 1. pre-LTCM and

2. post-LTCM.

Pre-LTCM

The concept of collective investing has been formally in

existence since 1822 when King William of the Netherlands set

up the first investment fund, to him being the pooling of money

to make investments for the common good of those who had

invested their money.13 After the fund set up by

King William in the Netherlands, the Scottish Life Company set

up a mutual fund in Scotland, that being recognised as the

second recorded mutual fund in history.14 The

investment technique of pooling money was proving favourable

with investors and this is the foundation of both mutual and

hedge funds. By 1830 the New York Stock Exchange had been

formed with a small number of listed companies and

organisations were investing in these listed companies as a way

of providing pensions...